'Stupid Stimulus' Courts Disaster

As we anticipated in "Knee-Jerk Fed Reaction Doesn't Add Up," faulty stimulus hopes based on the Fed minutes quickly evaporated, leaving markets meaningfully lower within 24 hours (with the exception of precious metals, which have gone vertical in recent sessions).

We are "stimulus skeptics" through and through, not for moral reasons but simple logistical ones.

Simply put, historical evidence suggests that, the majority of the time, stimulus is a form of malinvestment (Malinvestment is an Austrian economics term, referring to capital that has been invested or allocated badly).

Basically, when you try to juice the economy through artificial means, driven through artificial government channels, the guiding hand of the free market is negated.

As a result, the stimulus being applied flows to the wrong places, creating signal distortions and generally making things worse off than they were in the first place.

This is why we feel strongly that the various Fed governors who repeatedly call for more stimulus are idiots. Charles Evans and the like are on the record as saying they believe more stimulus is needed immediately, and at the first sign of ongoing weakness in the economy, but they never address the fact that historical evidence does not support the notion that stimulus does any good.

It should be clarified that there is a difference between stimulus and emergency liquidity measures.

For example: In the immediate aftermath of the Lehman meltdown, it was widely acknowledged that the global financial system had experienced the equivalent of a massive heart attack. Under those circumstances, the Federal Reserve, Treasuryand other entities collectively behaved like emergency paramedics trying to keep the patient from going into fatal cardiac arrest. In such extreme circumstances, liquidity injections into the system make sense, for the same reason that a hospital may pump you full of stabilizing drugs, temporarily, if you are wheeled in on a stretcher at death's door.

But to hear calls for more stimulus years after the fatality risk has passed is absolute lunacy. Again, there is simply no historical context, or logical reason, to believe that ongoing stimulus helps anything. There are only political rationales, hidden mandates, systemic corruption diverting benefits to insiders and a staggering degree of bad policy and bad thinking.

Two recent news stories do a great job of highlighting the folly of stimulus, providinggraphic example of the dangerous place we are headed.

After three decades of torrid growth, China is encountering an unfamiliar problem with its newly struggling economy: a huge buildup of unsold goods that is cluttering shop floors, clogging car dealerships and filling factory warehouses.

The glut of everything from steel and household appliances to cars and apartments is hampering China's efforts to emerge from a sharp economic slowdown. It has also produced a series of price wars and has led manufacturers to redouble efforts to export what they cannot sell at home.

The severity of China's inventory overhang has been carefully masked by the blocking or adjusting of economic data by the Chinese government - all part of an effort to prop up confidence in the economy among business managers and investors.

The story goes on to describe inventory levels piling ever higher, with factories continuing to churn out "stuff" at full clip, because the factory owners will not or cannot shut down production.

Wu Weiqing, a wholesaler cited in the piece, says: "My supplier's inventory is huge because he cannot cut production - he doesn't want to miss out on sales when the demand comes back."

This may be a legitimate, if foolhardy, rationale. It may also be that Mr. Wu's supplier is loaded to the hilt with bank loans that have to be perpetually refinanced. As such, if he turns off the machines, his ability to roll over his loans may be curtailed, resulting in instant bankruptcy.

The irony is delicious. After years of perpetuating a glut of "stuff" via vendor finance relationship with the West, in which Americans bought Chinese goods on credit with paper dollars that were recycled back into Treasury bonds, perpetuating the cycle viahousing bubble, China has now glutted its own domestic market with "stuff" via the same myopic policies, which emphasize "keeping things going" at all costs, no matter how ultimately destructive.

And then you have utter nitwits like Fed Governor Charles Evans, who recently said this:

The Federal Reserve should do more to boost the United States economy as the most recent uptick in employment data is still not good enough, Chicago Fed President, Charles Evans, told a news briefing in China on Thursday.

"The (July) employment data was a little better than expected," said Evans, one of the Fed's most dovish policymakers and who has led the most recent calls for active easing of monetary policy.

"It is still not nearly good enough," he added. "We need 300,000 to 400,000 (new jobs) a month to get to where we should be."

And how is the Fed going to make that result come about, Mr. Evans? How is stimulus going to create jobs?

The answer is, Evans has no idea. His ideas are no more credible than the notion of planting magic beans and climbing the stimulus beanstalk to the magical full employment castle in the sky. We try hard not to be overly cynical, but when government officials are given this much free rein for public displays of stupidity it is a very tough job.

Back to China: Now that China has a "stuff" glut, what exactly is more stimulus supposed to do? Chinese banks recently stepped up their lending, by implied government mandate, to help counter hard landing risks. But who are those banks lending to? The factories now churning out mountains of 'stuff' that Chinese consumers don't want?

Unhelpful stimulus and unneeded liquidity merely ends up pooling in bank vaults, like stagnant water. Either that, or it winds up getting directed to unhelpful and unuseful places as a form of malinvestment, for example aiding factories in the ongoing production of 'stuff' that no one wants and that will never turn a profit.

The evidence is clear: stimulus is stupid, for reasons that should be obvious and apparent to anyone who believes in the power of free markets to channel and direct resources. Stimulus by definition, insofar as it is implemented and doled out by quasi-government authorities, is a violation of the very free market mechanisms that allow capitalism to function.

A second news story this week, on retail discounter Big Lots (NYSE:BIG), shows us where stimulus dependency will take us. Via Marketwatch:

Big Lots, which helps manufacturers clear their warehouses of overstocked and discounted goods, targets cost-conscious customers who are being pinched by higher fuel and food prices.

Earlier this month, J.P. Morgan Chase & Co. (NYSE:JPM) downgraded Big Lots to underweight, saying the company "is in the wrong place at the wrong time." It referred to the retailer's "stretched core consumer demographic" of between $42,000 to $45,000 in household income, and more-discretionary shopping profile. It added that only 30% of Big Lots' sales come from "need-based consumables" versus nearly 70% at Family Dollar Stores Inc. (NYSE:FDO) and Dollar General Corp. (NYSE:DG).

(Click to enlarge)

Why is the stock performance of Big Lots a harbinger of what's to come? Because it shows how stimulus is killing the lower class, and increasingly killing the middle class, through the erosion of discretionary spending power via creeping food and energy inflation - or, as Doug Kass calls it, "screwflation," because the lower and middle classes are getting screwed.

The bottom line irony is that, to the degree that stimulus "works," it does so by helping the rich get richer through the boosting of paper assets.

In a "stimulated" economic environment, interest rates remain low, which is excellent for credit worthy borrowers who can finance at rock bottom rates. At the same time, though, the low rates are not available to the vast majority of the populace with middling to poor credit. The same dynamic plays across businesses with "rich" Fortune 500 corporations able to lock in long-term borrowing rates below 2%, whereas struggling small businesses - which make up the backbone of the U.S. economy - get no real finance help at all.

In the above sense, stimulus is an extension of the "socialism for the rich, capitalism for the rest" type thinking that fueled the bailouts of the global banking system. But stimulus is also ultimately self-defeating, even for the wealthy, because a hollowed out U.S. economy in which the middle class grows poorer by the day is ultimately headed for severe political backlash, economic implosion, or some combination of both.

As traders, we are agnostic in terms of moral interpretation of economic policies. But we are keenly interested in real world implications of how policy will impact prices. It appears clear to us at this juncture that "stupid stimulus," and the fact-free, logic-free, hope-jag driven emphasis on more government intervention to shore up markets, is going to lead to a very, very bad end.

Ironically, this bad end does not require stock prices to go lower - it is conceivable that the Federal Reserve could step in and buy equities if things get bad enough! - but what does seem clear is that, as long as government officials do stupid things that fly in the face of free market economic principles, with dumb commentators and myopic Wall Street and business leaders cheering them on, net results will go from bad to worse.

All in all, it is an excellent time to possess the capability to go short, as we have stated repeatedly. In our real money portfolios, where a majority of our liquid net worth is invested, we are now more than 40% net short with open profits on all positions.

Disclosure: I am short EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Short AUDUSD.

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